By David D. Tawil
I can't even say that FairPoint Communications is
misunderstood. It's not even known.
Originally, FairPoint was a collection of local
telephone exchanges spread throughout the U.S. Now
it’s the Charlotte, NC-based operator of the
un-sexy business of land-line telephone and data services to
residential and business customers in 18 states. But the
company is a favorite of short sellers. Unfortunately for them,
FairPoint’s relative anonymity is going to be
great for the bulls and absolutely perilous for the shorts.
Despite an enterprise value of about $1.1 billion,
FairPoint’s equity has traded near $7 per share,
giving it a total market-capitalization of only $180 million.
How did the stock become so depressed? Short-interest in the
company’s stock is gigantic. By last count, shorts
were 26% of the outstanding float (5.1 million of 19.4 million
shares, with 54 days to cover). Shares were shorted at prices
as low as $3.50, signaling a belief that FairPoint must be a
candidate for a default or bankruptcy. That
couldn’t be further from the truth.
Our price target is $25/share. The company is
undervalued by a wide margin.
FairPoint is now valued at about four times its
past year’s adjusted EBITDA ($260 million), while
peers average closer to six times, and FairPoint’s
EBITDA is expected to grow. We expect EBITDA to grow to $280
million in 2012 and to $300 million in 2013. In addition, the
company’s annual capital expenditures (CapEx) will
come down from $176 million in 2011 to $145 million in 2012 and
$120 million in 2013.
Ultimately, for most investors in the equity of
telecom companies, it’s all about free cash flow
and dividends. With EBITDA moving higher and CapEx coming down,
free-cash-flow will move from $7 million in 2011 to $50 million
in 2012 and $100 million in 2013. With a market capitalization
of only $180 million, a 28% free cash flow yield for 2012 and a
55% free cash flow yield for 2013 is extremely valuable.
So why are the shorts so confident? Partially, it
has to do with a mucked-up acquisition, which has been remedied
by the hard work of new management during the past 18
In 2007, using a lot of leverage, FairPoint
purchased Verizon’s telephone network in Maine,
New Hampshire and Vermont (its Northern-New England, or NNE,
network). Through the NNE acquisition, FairPoint increased its
revenue base by six times (in 2007, NNE had
revenue $1.1 billion versus the FairPoint’s
telecom group revenue of $283 million), and tripled its debt.
Through the acquisition, FairPoint became the 7th largest local
telephone company in the U.S. (with 1.2 million access
Upon acquisition, FairPoint had difficulty assuming
the operational responsibilities (installation, service,
billing, etc.). The cutover from Verizon’s systems
took much longer than expected and was problematic, leading to
an increased cost structure (head-count) and lost market share.
This led to a trip through Chapter 11 bankruptcy, which
concluded in January 2011 with the reduction of
FairPoint’s debt load by 60% and the introduction
of a new management team.
Then there’s the issue of the
company’s earnings margin, which has historically
been lower than that of its competitors as a result of a higher
cost structure. Specifically, FairPoint has higher-than-average
capital expenditures, which will end this year. And, FairPoint
has operated with a higher-than-average workforce, which has
started to be right-sized. With these changes,
FairPoint’s EBITDA margin should come into line
with the industry average, leading to increased cash flow.
For the past few years, FairPoint has spent up to
40% of its annual CapEx on the buildout of its NNE network
(this was agreed to with regulators as part of the
company’s exit from bankruptcy). That buildout
will be completed in 2012 and annual CapEx is expected to fall
by $50-60 million (in 2011, CapEx was $176 million; CapEx for
the last 12 months is $128 million).
And by industry measures, FairPoint is considerably
overstaffed. FairPoint’s peers average about 340
lines per employee; at 3,600 employees,
FairPoint’s staffing was 313 lines/employee
(FairPoint, December 2011 investor presentation). In 2011,
FairPoint reduced its headcount from about 4,000 to about
3,400. Those cuts are expected to save the company $35 million
per year, and FairPoint can continue to reduce headcount. The
2011 reduction-in-force focused exclusively on unionized
workers among the International Brotherhood of Electrical
Workers; the Communications Workers of America workforce can be
similarly trimmed, leading to about $70 million of total annual
FairPoint’s management has ambitiously
predicted that the second-half of 2012 will be the inflection
point for the company’s revenue trend. That is an
astounding possibility for a fixed-line communications company,
which, like the rest of the ground-losing industry, faces
competition from cellular and cable. I know the management team
well; they are a very conservative bunch and they
wouldn’t set expectations beyond what they think
In NNE, FairPoint is the incumbent carrier (the
main telephone company in each state). On average, incumbent
carriers have greater than 40% market share. FairPoint is well
below the average market share. To address that deficiency,
FairPoint has made serious changes and progress toward greater
penetration. The company’s primary focus is on the
business customer. FairPoint has recently hired a chief revenue
officer and, in early 2012, reached landmark legislation in all
three NNE states that allows the company to compete more
successfully with cable providers and competitive local
exchange carriers. Moreover, to date, the company has slowed
its voice line loss to industry-leading levels and has been
gaining steam on its broadband growth.
It’s not just that the shorts
don’t know the fundamental story. They also
don’t appreciate the precarious technical position
they are in.
More than 50% of FairPoint’s equity is
concentrated in a half-dozen investors whose shares are not
available for borrow. In addition, there are limited additional
shares available for borrow; the technical machinations are
complete, now the fundamentals will take over.
The short interest has been building over time.
More equity was shorted even when the share price was below $4.
The only justification for that position is that the company
will head into bankruptcy and the shares will be deemed
Contrary to the thesis necessary to support the
short position, since exiting bankruptcy, FairPoint has
increased its cash position by 400%, and at the end of its
2nd quarter, the company had total
liquidity greater than $100 million. In conclusion, there is no
chance that the company will violate its debt covenants.
Moreover, as a levered equity ($970 million secured debt at
Libor+450 due in 2016), any expansion in the
company’s valuation multiple will have a
particularly intense effect on the share price.
Moreover, on September 4, 2012, FairPoint made a
voluntary payment of $25 million on its secured debt.
Management is basically saying they are comfortable with the
operations and cash flow generation and that the cash is better
utilized to pay down debt.
The company’s path forward is clear.
All of the growth is in NNE. By contrast, the telecom group is
mature and ripe for divestiture. The company can and should
monetize those assets (which have been kept operationally
separate from the NNE assets) and use the proceeds to retire
debt and delever.
Next, the company will be able to refinance its
remaining debt (to allow for equity dividends, among other
things) and continue to optimize operations in NNE.
By the end of 2013, FairPoint can achieve $100
million of pro forma net free cash flow. A
50%+ equity dividend is stupendous. Shorts sellers: Watch
David D. Tawil is co-founder and
portfolio manager for Maglan Capital, a New York hedge fund
focused on distressed and event-driven investments.